Buy rating on NTPC; Disinvestment an overhang

Meaningful pick-up in capacity addition from this year to support earnings

WE upgrade to Buy (from Hold) as we find upside after the recent correction. We believe NTPC’s RoE (return on equity) has bottomed and will now expand because: (i) as coal shortages abate, existing and new plants should be able to recover their base RoEs; (ii) accelerated capacity addition in FY16-18 should lead to a smaller portion of equity stuck in projects under construction (which earn no returns); and (iii) NTPC intends to increase its leverage. While government divestment is an overhang, we advise buying during any resultant weakness.

Our target price(TP) decreases 9.6% despite cutting our earnings estimates and rolling over the valuation base to Sep-17e from Mar-17e. We forecast firm-level FCFs (free cash flows) for the next 10 years, assume a terminal growth rate of 3% and discount them using a WACC (weighted average cost of capital) of 9.6% versus 10% previously.

We expect a meaningful pick-up in capacity addition over FY16-18 to revive growth in regulated equity which drives a 17.4% earnings CAGR (compound annual growth rate) over FY16-18. We find the stock cheap at 9.6x FY17e P/E (price-to-earnings ratio) with a 4.5% dividend yield.

Lowering estimates to factor lower utilisation: We cut our sales estimate by 8.2%/10.6% for FY16/17e as we factor lower power plant utilisation based on our view that utilisation of coal fired power plants will not improve despite a potential revival in electricity demand because of continuing strong power generation capacity additions in the country. Lower utilisations will mean lower plant efficiencies—this reduces the additional RoE that NTPC can generate through efficiency gains. It also leads to lower utilisation based incentives (NTPC gets R.50/kwh as incentive for generation in excess of 85% utilisation).

However, this will be partly offset by more plants recovering their base RoE on better coal availability. The company is also making efforts to reduce operating expenses below regulatory benchmarks to improve RoEs. Overall the cut in sales estimates on lower utilisation leads to 8.4%/4.4% reduction in our profit after tax estimates

Declining RoE leads to stock under-performance: NTPC’s stock has underperformed for the past several years as its RoE has progressively deteriorated on multiple issues. Initially, capacity additions were delayed. When capacity additions started coming through, power plants faced domestic coal shortages which led to reduced availability-based incentive revenue. Some plants were not even able to earn base the RoE of 15.5%. These plants were also unable to earn higher RoEs from efficiency gains as low utilisation led to lower power plant efficiency. This was compounded by a decline in electricity demand which hit NTPC’s stream of revenue from Unscheduled Interchange (UI)charges.

Subsequently, new tariff regulations introduced by CERC starting FY15 reduced NTPC’s scope to increase RoE through efficiency gains. We estimate that new regulations led to a reduction in return on regulated equity (RoRE) for NTPC’s power plants from its peak of 23% (when there were no coal shortages) to 19%-20%. With Coal India showing meaningful improvement in coal production over the past two quarters, NTPC management indicated that its plants no longer face coal shortages. However NTPC’s plant utilisations have not improved because of low electricity demand from discoms. Despite this, we believe that NTPC’s RoE has bottomed out and will improve.

Earnings growth to revive on capacity additions: NTPC currently has an installed capacity of 44.4GW and has another 22.7GW of capacity under construction to be installed by 2020. We estimate that about 13GW (30% of current installed capacity) of capacity will come on stream by FY18 despite assuming a one-year delay to company’s targets. In addition, the company is committed to add about 10GW of solar power generation capacity by FY20.

High capacity addition will also meaningfully reduce the portion of NTPC’s equity that is stuck in projects under construction and earning no returns. Consequently, overall company level RoE will go up even though profitability of the operating power plants (RoRE) goes down as we assume lower utilisation. We forecast NTPC’s regulated equity as a percentage of book value to improve from 50% in FY15 to 65% in FY18 and 75% by FY20.

Realistically, we estimate that NTPC can add 2.5GW capacity addition every year starting FY17. If we conservatively assume solar capacity addition of 8.5GW till FY20e- it will result in R28 increment to our fair value estimate for NTPC.

Risk to our call: Downside risks include: (i) NTPC’s tripartite agreement, which ensures timely payment to the company, ends in FY16—if this is not renewed or if discoms’ financial situation does not improve, NTPC is at risk of delayed payments; (ii) delay in CoD (commercial operation date) of projects will lead to no improvement in RoE, (iii) worse than expected utilisation of coal plants, and (iv) delays in the government’s proposed divestment stake in NTPC. We expect the divestment to remain an overhang on the shares; the sooner it is done, the sooner investors will start focusing on company fundamentals.